Havoc's Blog

Most people know about the price/earnings
ratio. If you want to learn one more thing about financial
numbers, return on
equity could be a good choice.

Return on equity is annual profit divided by net worth. If you have
$100 in net worth, and make $10 in annual profit, then you are making
10% ROE. If you think you can make a 15% return elsewhere, you could
sell your assets to net $100 in cash, and invest in the 15% return
elsewhere.

Reinvestment

Depending on the nature of the business, maybe you can add more net
worth and make more profit. If you’re making $10 on your $100 tied up,
maybe you can add another $100 and now make $20. Still 10% ROE, but
more money made.

This is supposed to determine what companies do with their profits. If
they can reinvest into the business (or at least, some business) at a
decent ROE, then they should do so. But if they can’t, they should be
paying the profits out as dividends their stockholders can invest
elsewhere.

Say you propose a project for your company to undertake. The key
questions might be the return on equity, and how much equity can be
invested. (Making 500% returns on twenty bucks might not be very
interesting for a large company.)

Where do earnings come from?

Return on equity can be broken down to understand why a
business activity is making money. An equation called the DuPont system
tries to do this.

The DuPont system is:

  ROE = 
    (Margin, how much of each sale is profit) x
    (Asset Turnover, how quickly inventory is sold) x
    (Financial Leverage, how much did we borrow)

• Higher margin means more profit per dollar of stuff sold
• Higher asset turnover means selling stuff more quickly
• Higher financial leverage gives you more stuff to sell or more productive
  assets for the same net worth – you’re buying machinery or inventory
  with a loan

Different kinds of business make money in different ways, even in the
same industry. For example, some few-months-old numbers for Dell and
Apple (numbers don’t quite add up due to rounding error; numbers are
from Morningstar):

• Dell: 5% margin x 2.0 turnover x 4.4 leverage = 43.8% ROE
• Apple: 15.4% margin x 0.9 turnover x 1.8 leverage = 24.2% ROE

Not surprising. Dell makes money by selling a lot of stuff quickly
for a low profit, using more borrowed money. Apple makes money by
selling more slowly, but for higher profits. Both are workable models,
neither one is wrong. Both companies are single-minded about their
approach; Dell has focused on increasing turnover rather than
increasing margin, and the opposite for Apple.

Leverage is the most dangerous way to make money, because if the
margin flips negative the ROE goes negative. Banks make
their money on leverage, and they are supposed to be conservative about
ensuring the margin stays positive, for example by only making sound
loans to people who can pay them back.

The worst kind of business is high leverage with a low, but unstable,
margin. Example (other than subprime lending): airlines.

• American Airlines a few months ago: 2.2% margin x 0.8 turnover x 10.8 leverage = 19% ROE
• American Airlines now: -7.1% margin x 0.8 turnover * 17.42
  leverage = -98% ROE

Airlines are always about to go bankrupt. The margin depends on ticket
prices (which they can’t raise very much without losing sales),
and fuel costs (which they don’t control and which bounce around
wildly). They can’t control the margin, and on top of that the margin
is low so requires high leverage to make the ROE worthwhile.

Perhaps this explains why airlines are awful to customers. They can’t
afford to spend any money.

Applications

Here’s what a business activity should not be about: growing revenue
for its own sake. Often it’s possible to grow revenue by reinvesting
in a business (say, hiring more salespeople, building more
manufacturing capacity, running ads) … but the ROE may be too
low. If customers don’t really want the increased sales enough to pay
for them, then margins are low or even negative. At that point it
would be better to invest in an index fund, or a savings account,
rather than in the business. It doesn’t make sense to spend a
bunch of money selling stuff people don’t want.

ROE determines what sort of price/earnings ratio is acceptable,
because (in theory) the earnings will be reinvested at the ROE.
If an investment pays 10% per year reinvested at 10%, that is worth a
lot more than 10% per year reinvested at 2%. So the stock price should
be higher relative to earnings.

I find it helpful to flip price/earnings over (earnings yield). It
gives me much more pause to invest in something yielding 2% than
something with a P/E of 50. Higher P/E almost sounds good – it’s
higher, right? Maybe this explains the tech bubble.

Both ROE and P/E require all kinds of adjustments and normalizations
to remove accounting artifacts before they mean all that much. That’s
one reason it’s futile trying to buy stocks if you aren’t a qualified
analyst (or relying on one).

As concepts, though, these ratios should help you decide what makes
sense for the businesses you’re involved with as an employee or owner.
Is your company more focused on turnover or on margin, for example?
Is your new project proposal profitable enough – would you personally
invest in it instead of a mutual fund, if it were your money?

(This post was originally found at http://log.ometer.com/2008-08.html#3)